Why Small Is the New Big for This Organic Food Retailer

The story of David and Goliath has important lessons for investors, as it shows how size (or the lack thereof) can be used intelligently as a competitive advantage against bigger-sized rivals. One such David in the organic food retail space is The Fresh Market.

There is a tendency for most people to view size as a proxy for success and profitability, but this is hardly true in reality. The Fresh Market(NASDAQ:TFM) has the smallest store size of the listed organic food retailers, but it boasts significantly higher profitability than its peers such as Whole Foods Market(NASDAQ:WFM) and Sprouts Farmers Market(NASDAQ:SFM).

The Fresh Market thrives on a small-box format with an average store size of 21,000 square feet. In contrast, the stores at Whole Foods Market and Sprouts Farmers Market are much larger, averaging about 38,000 square feet and 27,000 square feet, respectively. However, store size seems to be inversely related with profitability.

According to Morningstar data, The Fresh Market achieved a best-in-class operating margin of 7.6% in the most recent financial year. In comparison, Whole Foods Market and Sprouts Farmers Market delivered operating margins of 6.8% and 3.9%, respectively.

If return on invested capital, or ROIC, is used as a benchmark for profitability instead, the disparity is even more glaring, with The Fresh Market boasting of a 29% ROIC, double that of Whole Foods Market's 14% ROIC.

Customer service and store experienceSince customers of natural and organic food retailers pay a price premium relative to the run-of-the-mill grocers, they are more demanding of higher customer service standards and unique store experiences. Store size plays a big part here.

Whole Foods Market, with the largest store size of its peers, tries to pack as many features as possible to utilize its large floor space. Sit-down eating areas and customer service booths are typical of Whole Foods Market's stores. Whole Foods Market goes a step further by having massage chairs and wine bars at certain stores.

A larger store size also allows Whole Foods Market to put more specialized staff on the floor to serve customer needs better. It usually organizes its staff into as many as 10 different teams based on specific product offerings.

On the other hand, both Sprouts Farmers Market and The Fresh Market place their faith with smaller store formats. Sprouts Farmers Market believes that its smaller store size enables customers to walk in and immediately have the entire view of its store in one quick glance. This is made possible with Sprouts Farmers Market's open floor plans and low profile displays at about six feet high.

The Fresh Market uses its small store size to its advantage, creating what it calls a 'Neighborhood Grocer' atmosphere. Making full use of the space available, its full-service departments such as dairy, bakery, meat, and seafood are placed side by side with each other, facilitating closer interaction between staff and customers.

Good customer service works hand in hand with a wonderful in-store experience. Inline with its positioning as 'Neighborhood Grocer,' The Fresh Market's customers can have coffee on the house and have service staff help them carry their shopping bags to their vehicles.

Product range and mixThe biggest problem with large stores is that they lead some retailers to lose focus and try to be everything to everyone. Unsurprisingly, the number of SKUs (stock keeping units) that the three organic food retailers carry is proportional to their respective store sizes. Whole Foods Market and Sprouts Farmers Market carry about 21,000 and 16,500 SKUs on average, respectively.

Instead, a small-box format is a blessing in disguise for The Fresh Market, as it has only about 10,000 SKUs in its stores with a strong focus on perishables, accounting for two-thirds of the sales mix.

By concentrating its purchases on a smaller number of SKUs than its peers, The Fresh Market benefits from lower inventory holding costs and stronger bargaining power with suppliers. Also, perishables tend to sport higher margins than non-perishables.

The results speak for themselves. The Fresh Market has a 400 basis point advantage in gross margin over Sprouts Farmers Market. In addition, The Fresh Market's gross margin of 34% is comparable to price leader Whole Foods Market's 35.8% margins.

Growth aided by small-box formatWith Nutrition Business Journal forecasting sales of natural and organic foods to grow by 9% through 2020, all three listed organic food retailers have ambitious expansion plans in place. However, the availability of suitable real estate space is a natural constraint on such expansion activities. Since The Fresh Market has lower space requirements, the universe of suitable store locations is much larger given that more sites of different configurations will fit the bill.

Foolish final thoughtsA smaller store size format has meant bigger profits for The Fresh Market. Despite having sales about one-tenth of market leader Whole Foods Market, The Fresh Market has managed to deliver superior profitability due to the attractive economics of its smaller size store format. In addition, its small-box format also suggests that it is more flexible in the search for suitable sites for new store expansion.

John Mackey, co-CEO of Whole Foods Market, is a member of The Motley Fool's board of directors. Mark Lin has no position in any stocks mentioned. The Motley Fool recommends The Fresh Market and Whole Foods Market. The Motley Fool owns shares of Whole Foods Market. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Author

Mark is a private value investor and is the author of CheapskateInvesting.com website which uses a systematic quantitative screening approach to filter the global stock markets for cheap cigar-butts and wide-moat compounders.